Rackspace Hosting Is a Winner -- Here's Why

Here's what happens when you hand the business to the fanatics.

With Worldwide Invest Better Day upon us, we here at The Motley Fool are profiling dozens of companies that might be worth investing in. Here's a closer look at Rackspace Hosting (NYSE:RAX), a web hosting and cloud-computing specialist known for offering exceptional customer support.

History and overview In 1998, web hosting was a relatively new idea. Most users just knew they wanted a website. Rackspace wasn't much different; the founders only shifted strategy from consulting to hosting when they couldn't find a hosting service that met their needs.

You might even say the entire business model was a fortunate accident. In an interview at Rackspace HQ last year, company co-founders Pat Condon and Dirk Elmendorf said they were swayed by arguments from outsiders who argued that it cost too much to keep customers happy. Only after David Bryce joined the company as head of service and support did the culture change.

Today, every call to support is answered by a human being. There are no time limits and no topic is out of bounds. Indeed, "Rackers" (i.e., employees) are encouraged to help clients with any problems they might have, even if it's with a system Rackspace doesn't maintain.

Management calls this approach Fanatical Support -- and yes, the capitalization is deliberate. Rackspace has trademarked the phrase, citing it as a key differentiator with Amazon.com(NASDAQ:AMZN), its chief competitor in website and cloud applications hosting. Stories of going above and beyond are celebrated monthly in a companywide meeting in which one Racker is singled out as the top "Fanatic," and then promptly fitted for a straitjacket, the company's highest employee honor.

The business On a practical basis, it's best to think of Rackspace as a landlord with only two types of digital tenants. Dedicated cloud customers specify which hardware and software is to be hosted on their behalf. Public cloud customers require a certain variety of services while allowing Rackspace to handle the hardware and other back-room specifics. The latter model is more profitable, though brings in less revenue:

Segment

2011

2010

2009

Dedicated Cloud

$835,877

$679,888

$572,606

Public Cloud

$189,187

$100,667

$56,381

Total Revenue

$1,025,064

$780,555

$628,987

Source: SEC filings. Figures in thousands.

Betting bigger on the public cloud has helped Rackspace attract nearly 10,000 new customers per quarter with regularity. What's more, the flexible nature of these engagements -- remember, Rackspace controls the hardware for public cloud customers -- has pushed revenue per server consistently higher over the past four fiscal quarters:

Key Indicators

Q2 2012

Q1 2012

Q4 2011

Q3 2011

Monthly Growth in Installed Base

1.0%

0.7%

1.2%

0.9%

Customers

190,958

180,866

172,510

161,422

Servers Deployed

84,978

82,438

79,805

78,717

Monthly Revenue Per Server

$1,270

$1,238

$1,191

$1,155

Annualized Return on Capital

15.5%

15.0%

17.2%

14.8%

Source: Rackspace press releases. Dollar figures in thousands.

What do you get when zero churn meets a large sales pipeline? Growth. Exceptional growth, really, when you consider that Rackspace competes not just against Amazon but also giants such as AT&T(NYSE:T) and scrappy upstarts such as 8x8(NASDAQ:EGHT):

Metric

FY 2011

FY 2010

FY 2009

Revenue Growth

31.3%

24.1%

18.2%

Gross Margin

69.8%

68.0%

68.1%

Net Margin

7.1%

5.7%

4.6%

Cash / Debt and Leases

$159.9 / $139.1

$104.9 / $131.7

$125.4 / $167.4

Source: S&P Capital IQ. Dollar figures in millions.

Here are three other things you, as a potential investor, should take away from this data:

Improving returns on capital (see the middle table) also speak well for how Rackspace uses debt to fund growth. Leverage won't be an issue so long as this remains true.

The Foolish takeaway Think about how you invest your own resources. Do you buy what you need at a good price? Do you invest the excess in things that matter, whether for the benefit of yourself, your family, or a cause you care about? Are you careful not to pile up debts you can't pay off? Companies and management teams are subject to these very same tests. Rackspace's team appears to be delivering.

Care to learn more? There's plenty of source material freely available on the web:

Author

Tim Beyers first began writing for the Fool in 2003. Today, he's an analyst for Motley Fool Rule Breakers and Motley Fool Supernova. At Fool.com, he covers disruptive ideas in technology and entertainment, though you'll most often find him writing and talking about the business of comics. Find him online at timbeyers.me or send email to tbeyers@fool.com. For more insights, follow Tim on Google+ and Twitter.